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What to expect for the 2Q17 Inflation Report

June 20, 2017

The IR may signal the need to reduce the uncertainty and the scope of possibilities on the future course of monetary policy.

The Brazilian Central Bank Monetary Policy Committee (Copom) is scheduled to publish its second Inflation Report (IR) for 2017 this coming Thursday. We believe that, following the recent communication approach by monetary authorities, the IR may signal the need to reduce the uncertainty and the scope of possibilities on the future course of monetary policy, as well as the conditioners of its reaction function, which would be consistent with our scenario of an interest rate cut of 75 bps in July, although the decision will still depend on upcoming data. We estimate declines in the forecasts for inflation in 2017 and relative stability for 2018. In the market scenario, we expect inflation forecasts to be at 3.6% for 2017 and 4.5% for 2018. In the hybrid scenario, with the Selic rate path as in the Focus survey and constant exchange rate, we expect inflation forecasts to be at 3.6% for 2017 and 4.4% for 2018.

The Copom will release its Inflation Report for the second quarter of 2017 this coming Thursday. The table below summarizes our attempt to replicate the Central Bank (BCB) model, based on the market scenario (exchange rate and Selic according to the Focus survey) and hybrid scenario (constant exchange rate and Selic according to the Focus survey). We use June 16th as the cutoff date.

In the market scenario, the Focus exchange rate forecasts stand at 3.30 reais per dollar for 2017 and 3.40 reais per dollar for 2018. For the Selic rate, the Focus survey’s expectations are at 8.50% for both 2017 and 2018. For 2017, we expect the inflation projection to decline to 3.6%, from 4.0% at the May meeting; for 2018, we anticipate an inflation forecast of 4.5%, from 4.6% at the May minutes.

In the hybrid scenario, we expect the inflation forecast for 2017 at 3.6%, below the estimate provided in the last inflation report (3.9%). For 2018, we anticipate a slight increase to 4.4%, from 4.3% at the first quarter IR.

We believe that, following the recent communication approach by monetary authorities, the IR may signal the need to reduce the uncertainty and the scope of possibilities on the future course of monetary policy, as well as the conditioners of its reaction function.

Given the relatively advanced stage of the easing cycle, we expect the committee to keep signaling, as expressed in the last Copom meeting, to the possibility of a slowdown in the pace of easing to 75bps in July.Such signaling, however, will continue to be dependent on economic data and the committee's assessment of the impact of heightened uncertainty on the reform agenda in the prospective inflation trend. As emphasized in the minutes, high levels of uncertainty for long periods may have a disinflationary impact by further slowing down economic activity, but also affect estimates for structural interest rates. The communication can also be modified, reducing the emphasis on a possible moderation of the rate cut, due to new evidence on inflation – IPCA inflation figure showed a substantial downside surprise in May – and due to inflation expectations - despite greater political uncertainty, the median forecast in the Focus survey declined for 2017 and has remained relatively stable for 2018.

In all, the risk is that the communication in the IR becomes less emphatic as to the adequacy of a moderate deceleration in the pace of rate cuts in its next meeting. This would be a clear signal that the committee is split between a 75 or 100 bps cut.

We maintain our expectation that the Selic rate will end 2017 and 2018 at 8.00%. We forecast, for now, a slowdown in the pace of rate cuts to 75 bps in July and to 50 bps in the following three meetings (September, October, and December), recognizing that the pace can be changed depending on new evidence on inflation and on activity data.

The risks to this forecast, in our view, seem to be symmetric. On the one hand, the output gap may be more disinflationary than we currently anticipate, especially in a scenario of greater uncertainty. On the other hand, this heightened uncertainty and difficulties in approving fiscal reforms may impact the equilibrium interest rate, leading to currency depreciation, with potential inflationary implications. There is also risk of tax hikes, given the government’s challenge to deliver the fiscal targets, which would also have inflationary impact.